Chapter 12 - Deferred Compensation and Nonqualified Plans

Question 1

Define IRC §83(b) Election

Answer 1

Election to include in gross income the difference between the FMV of restricted stock and its purchase price.

Question 2

Define Nonqualified Deferred Compensation Plan (NQDC)

Answer 2

A contractual agreement between the employer and an executive, whereby the employer promises to pay the executive a predetermined amount of money sometime in the future.

Question 3

Define Nonqualified Plans

Answer 3

Plans that do not meet the requirements of §401(a) and therefore do no have the benefits of a qualified plan.

Question 4

Define Nonqualified Stock Options

Answer 4

An option that does not meet the requirements of an incentive stock option. The exercise of an NQSO does not receive favorable long-term capital gains treatment but also does not require the holding period associated with ISOs.

Question 5

Define Option Price (Exercise Price)

Answer 5

Usually the FMV at the grant price.

Question 6

Define Phantom Stock Plan

Answer 6

A nonqualified deferred compensation arrangement where the employer gives fictional shares of a stock to a key employer that are initially valued at the time of the grant. The stock is later valued at some terminal point and the executive is then paid in cash the differential value of the stock as compensation.

Question 7

Define Rabbi Trust

Answer 7

An irrevocable trust that is designed to hold funds and assets for the purpose of paying benefits under a nonqualified deferred compensation arrangement. The assets in a rabbi tryst are for the sole purpose of providing benefits to employees and may not be accessed by the employer, but they may be seized and used for the purpose of paying general creditors in the event of a liquidation of the company. Assets within a rabbi trust are no currently taxable to the employee.

Question 8

Define Restricted Stock Plan

Answer 8

An employer provided plan designed to increase retention and compensate employees with a non-cash outflow. The plan pays executives with shares of the employer’s stock. The executive does not pay any amount towards the allocation of the stock and, in fact, is restricted by the employer from selling or transferring the stock.

Question 9

Define Salary Reduction Plans

Answer 9

A nonqualified plan designed to receive deferral contributions from executives to reduce their current taxable income.

Question 10

Define Secular Trusts

Answer 10

Irrevocable trusts designed to hold funds and assets for the purpose of paying benefits under a nonqualified deferred compensation agreement. A secular trust does not create a substantial risk of forfeiture for the employee. Assets set aside in a secular trust results in immediate inclusion of income to the employee.

Question 11

Define Stock Appreciation Rights (SARs)

Answer 11

Rights that grant to the holder cash in the amount equal to the excess of the FMV of the stock over the exercise price.

Question 12

Define Stock Option

Answer 12

A right to buy stock at a specified price for a specified period of time.

Question 13

Define Substantial Risk of Forfeiture

Answer 13

An income tax concept that relates to when income is subject to income tax. A substantial risk of forfeiture exists when rights in property that are transferred are conditioned, directly or indirectly, upon the future performance (or refraining from performance) of substantial services by any person, or the occurrence of a condition related to a purpose of the transfer and the possibility of forfeiture is substantial if the condition is not satisfied.

Question 14

Define Supplemental Executive Retirement Plans (SERP)

Answer 14

Nonqualified deferred compensation arrangements designed to provide additional benefits to an executive during retirement. Also referred to as top-hat plans.

Question 15

Define Title 1 of ERISA

Answer 15

Coverage, participation, funding, and discrimination requirements of ERISA imposed on qualified plans.

Question 16

Define Top Hat Plans

Answer 16

Plans designed to benefit a select group of top management of key employees.

Question 17

Define Wage Replacement Ratio (WRR)

Answer 17

An estimate of the percent of income needed at retirement compared to income just prior to retirement.

Question 18

What are the characteristics of deferred compensation arrangements?

Answer 18

1. They do not have the tax advantages of qualified plans.
2. They usually involve some deferral of income to the executive.
3. The employer generally does not receive an income tax deduction until the key employee receives a payment and it becomes recognizable as taxable income, thus following the traditional income tax matching principle of deduction by one party upon inclusion by another party.
4. There is a general requirement that the employee/executive have a “substantial risk of forfeiture” or else the government will claim the executive, while perhaps not having actual receipt of the money, has “constructive receipt” of the money and, therefore, current income subject to income tax.

Question 19

What reasons would you set up a deferred compensation arrangement for?

Answer 19

1. To increase the executive’s wage replacement ratio
2. To defer the executive’s compensation, or
3. In lieu of qualifed plans

Question 20

What are some different deferred compensation arrangements?

Answer 20

Golden Handshakes - severance package, often designed to encourage early retirement,
Golden Parachutes - Substantial payments made to executives being terminated due to changes in corporate ownership
Golden Handcuff - Designed to keep the executive with the company.

Question 21

What is not consider a deferred compensation arrangement?

Answer 21

• Most qualified plans
• Incentive stock option plans
• Nonqualified stock option plans
• Employee stock purchase plans
• Stock appreciation rights plans
• Standard bonuses that are paid withing 2 1/2 months after the close of the taxable year.

Question 22

What is the effect of a deferred compensation arrangement not meeting the requirements laid out in §409A?

Answer 22

All amounts deferred under the plan are currently includable in gross income to the extent that the amounts are not subject to substantial risk of forfeiture and to the extent that the amounts have not been previously includable in gross income.

Question 23

According to §409A, when can payments be paid from a deferred compensation arrangement? 6

Answer 23

• Separation from service
• Disability
• Death
• At a specified time or pursuant to a fixed schedule
• Upon a change in control, and
• Upon an unforeseeable emergency

Question 24

What is the tax benefits to employees under a deferred compensation arrangement?

Answer 24

The employee gets to defer the compensation to a time when he expects to be in a lower marginal income tax bracket and thus, at the date of receipt, expects to pay less income tax on the compensation than would have been paid currently.

Question 25

What is the tax benefits to employers under a deferred compensation arrangement?

Answer 25

Being as the IRC places a $1,000,000 limit on a public company’s deduction for compensation payable to any one of the top five executives of a publically traded company, should an executive elect to defer income over the $1,000,000 limit to a year in which the executive earns less than the limit, the employer would be able to deduct the total compensation over the period of deferral and subsequent payments.

Question 26

What is key about an employee deferring compensation to not be taxed under the doctrine of constructive receipt?

Answer 26

The fact that they elect to defer the income prior to earning it, not giving them the chance to be able to receive it as current income

Question 27

What are examples of what is not considered constructive receipt?

Answer 27

• An unsecured promise to pay
• The benefits are subject to substantial limitations or restrictions
• The triggering event is beyond the recipient’s control (i.e. the company is acquired)

Question 28

What is the general rule regarding payroll taxes and deferred compensation arrangements?

Answer 28

The payroll tax will apply at the later of the time at which the deferred income is earned or the point as which the deferred income becomes nonforfeitable.

Question 29

What Medicare taxes did the affordable care act create?

Answer 29

1. An additional Medicate tax of 0.9% on wages or self-employment above specified thresholds ($125k - $250k depending on filing status)
2. A 3.8% tax on certain amounts of net investment income.

Question 30

What are the advantages of setting up a NQDC?

Answer 30

1. Cash outflows are often deferred until the future
2. The employer will save on payroll taxes except for the 1.45% Medicare match (since the employee’s income is probably over the SS wage base)
3. The employer can discriminate and provide these benefits exclusively to a select group of key employees.

Question 31

What are the main types of NQDC plans? 4

Answer 31

• Unfunded promises to pay
• Secular trusts
• Rabbi Trusts
• Phantom stock plans
• SERPs

Question 32

What is the basic idea of a secular trust?

Answer 32

A place where deferred compensation assets cannot be seized by creditors, but that tax is only deferred until the participant is vested.

Question 33

What are the differences between a secular and rabbi trust?

Answer 33

• In a Rabbi trust the assets may be seized and used for the purpose of paying general creditors in the event of liquidation of the company (creating substantial risk of forfeiture)
• Therefore, any assets within a rabbi trust are not currently taxable to the employee yet provide significantly more protection to the employee than a simple unfunded promise to pay.

Question 34

What is the taxability of the income generated inside of a rabbi trust?

Answer 34

-Taxable to the employer, however, the employer will receive an income tax deduction upon distribution from the trust.

Question 35

What constituted the restricted period during which employers are prohibited from setting aside or transferring assets for the purpose of paying deferred compensation of an applicable covered employee with respect to a qualified defined benefit plan?

Answer 35

1. Any period where the sponsor of a defined benefit plan is a debtor in a Chapter 11 proceeding,
2. The six month period prior to, and the six month period following, a qualified defined benefit plan’s termination if the plan does not have sufficient assets to satisfy its liabilities upon termination, or
3. Any plan year, beginning in 2008, during which a qualified defined benefit pension plan of the employer fails to meet certain minimum funding levels and is in “at-risk” status.

Question 36

Why would plans use life insurance in their NQDC plan?

Answer 36

The cash surrender value is not taxed if payments are not made from the policy. A permanent life insurance policy provides the cash value that can be used to fund the deferred compensation and it provides a death benefit that can be paid to the employer to offset some of the costs of the deferred compensation arrangement.

Question 37

What is the benefits to using a Phantom Stock Plan?

Answer 37

• The employer has a deductible compensation expense equal to the payment made to the employee.
• It aligns the economic incentives of the executive of the company
• Because actual stock is not issued, the current stockholder’s equity positions to not become diluted.
• The cash paid out represents the differential value of the stock, meaning only the benefit of the gain in the share price and not the initial share price.

Question 38

What plans are statutorily exempted from Title 1 of ERISA?

Answer 38

Top-hat plans and unfunded excess benefit plans

Question 39

Define Black Scholes Method

Answer 39

An option valuation method

Question 40

Define Cashless Exercise

Answer 40

An exercise or an option where the option holder does not utilize any cash.

Question 41

Define Constructive Receipt

Answer 41

An income tax concept that establishes when income is includible by the taxpayer and therefore subject to income tax. Income is constructively received in the taxable year during which it is credited to the employee’s account, set apart for them, or otherwise made available so that he may draw upon it at any time or so that he could have drawn upon it during the taxable year if notice of intention to withdrawal had been given.

Question 42

Define Deferred Compensation Arrangments

Answer 42

An arrangement to pay an executive compensation in a future year.

Question 43

Define Disqualifying Disposition

Answer 43

If stock is acquired after exercising an ISO is disposed before either two years from the date of the grant or one year from the date of the exercise.

Question 44

Define Economic Benefit Doctrine

Answer 44

An employee will be taxed on funds or property set aside for the employee if the funds are unrestricted and nonforfeitable even if the employee was not given a choice to receive the income currently.

Question 45

Define Employee Stock Purchase Plan

Answer 45

A plan designed to benefit all or a large portion of an employer’s employees that gives employees an incentive to buy employer stock by allowing the employees to purchase the stock at a discounted price (up to 15%) and receive favorable tax treatment for any gains if the stock meets certain holding period requirements.

Question 46

Define Excess Benefit Plans

Answer 46

A type of SERP that is designed solely to provide benefits to excess of the benefits available in qualified plans based on the limits under IRC §415

Question 47

Define 401(k) Wrap Plans

Answer 47

A form of salary reduction plan that enables executives, who are subject to salary deferral limitations due to nondiscrimination rules, to contribute higher amounts than otherwise permitted under a 401(k) plan

Question 48

Define Grant Date

Answer 48

The date of issuance of a stock or option.

Question 49

Define Incentive Stock Options (ISOs)

Answer 49

A right given to an employee to purchase an employer’s common stock at a stated exercise price. If the requirements of IRC §422 are met, the employee will not recognize any taxable income at the date of the grant. Further, at the date of exercise, the employee will also not be subject to ordinary income tax on the difference between the FMV of the stock and the exercise price. This difference is a positive adjustment for the AMT calculation. When the employee sells the stock subsequent to the exercise, the difference between the sales price of the stock and the original exercise price is considered a long-term capital gain and there is a negative adjustment for the AMT calculation.

Question 50

What is the widespread use of NQDC’s attributable to?

Answer 50

• Their greater flexibility

- They have none of the disadvantages of qualified plans.

Question 51

What are the characteristics of NQDCs from an employer’s viewpoint? 7

Answer 51

• Unfunded promise to pay
• Not a qualified plan
• Cash outflows are deferred
• Employer saves on payroll taxes
• Income tax deduction deferred until paid
• Sometimes used if compensation exceeds $1M and therefore, non-deductible
• May discriminate among employees.

Question 52

What are the characteristics of NQDCs from an employee’s viewpoint? 5

Answer 52

• Employee as at risk for nonpayment
• Fund by using a rabbi trust; if unfunded, best with a financially secure company
• No current taxable income
• Employee saves on payroll taxes
• May provide future cash flow at lower income tax rate.

Question 53

When are stock options subject to the rules under IRC §409A?

Answer 53

When they are issued at a discount from fair market value.

Question 54

What are the two types of stock options?

Answer 54

• Incentive Stock Options (ISOs)

- Nonqualified Stock Options (NQSOs)

Question 55

What are the requirements for ISOs? 10

Answer 55

1. ISOs can only be granted to an employee of the corporation issued the ISOs.
2. The ISO plan must be approved by the stockholders of the issuing corporation.
3. The ISOs must be granted within 10 years of the ISO plan date.
4. The exercise of the ISO is limited to a 10-year period (5 years for 10% + owners)
5. At the date of the ISO grant, the exercise price must be greater than or equal to the FMV of the stock.
6. An ISO cannot be transferred except at death.
7. An owner of more than 10% of a corporation cannot be given ISOs unless the exercise price is 110% of the FMV at the date of the grant and the option term is less than 5 years.
8. The aggregate FMV of ISO grants must be less than or equal to $100,000 per executive. Any excess grant over the $100,000 is treated as an NQSO.
9. To qualify as an ISO, the executive must hold the stock for the greater of two years from the grant of the ISO or one year from the date of exercise of the ISO.
10. The executive must be an employee of the corporation continuously from the date of the grants until at least three months prior to the exercise.

Question 56

What is the taxation of an ISO on the grant date?

Answer 56

There is no income taxable to the employee if the exercise price is greater than or equal to the FMV of the stock. If it is less the difference is W-2 income and the employer will have a compensation expense for the same amount.

Question 57

What is the taxation of an ISO at the date of exercise?

Answer 57

The exercise will not create any regular tax impact for either the employer or the employer but will create an AMT adjustment for the executive equal to the difference between the exercise price and the FMV of the stock at the exercise date.
The exercise price creates the executive’s adjusted basis.

Question 58

What is the taxation on the sale of the stock from an ISO exercise after the holding period requirement?

Answer 58

The executive will receive favorable capital gain treatment on the appreciation of the employer stock above the exercise price provided the executive does not sell the employer stock before two years from the date of grant and one year from the date of exercise. If they have held it that long, the employer will never receive a tax deduction in relation to the ISO.

If the executive meets the holding period requirement and the value of the stock is greater than the exercise price of the ISO, the executive will have LTCG treatment on the appreciation above the exercise price and a negative AMT adjustment equal to the AMT adjustment at the date of exercise.

Question 59

What is the consequence when an ISO is sold in a disqualifying disposition?

Answer 59

Any gain of the sale of stock attributable to the difference between the exercise price and the FMV at the date of exercise is considered ordinary income and reported on the executive’s W-2 but is no subject to payroll tax or federal income tax withholding. Any gain in excess of the amount reported on the executive’s W-2 is short or long-term capital gain considering the executive’s holding period.At this time the employer has a tax deductible expense equal to the amount reported on the executive’s W-2.

Question 60

What happens in a cashless exercise?

Answer 60

At the time of the cashless exercise, a third-party lender lends the executive the cash needed to exercise the option and the lender is immediately repaid with the proceeds of the almost simultaneous sale of the stock. C cashless exercise of ISOs automatically trigger a partial disqualifying disposition since the holding period requirements will not be met.

Question 61

What is the difference between an ISO and a NQSO?

Answer 61

• The NQSO does not meet the requirements of the ISO
• The exercise of the NQSO does not receive favorable capital gain treatment.
• It does not require the holding period associated with ISOs

Question 62

What is the downside if you make an 83(b) election and but leave before the stock options are vested?

Answer 62

You have recognized income that you never saw and will not have a corresponding loss because you never had the shares of stock.

Question 63

What is the limit an employee has in regards to purchasing shares of employer stock throughout the year?

Answer 63

Limited to $25,000 of the employer stock per year based off the FMV at the date of the grant of the employer stock.

Question 64

What is the effect of a disqualifying disposition of employer stock bought through a ESPP?

Answer 64

Instead of the discount being treated as ordinary income it is treated as W-2 income and therefore subject to FICA.